For the regulators in charge of the global financial market’s infrastructure, new technologies are prompting a fundamental rethink of how payments and securities trades are settled.
Now the Committee for Payments and Market Infrastructures (CPMI), an international standards body, has published a report on wholesale digital tokens, the kind of technology underlying cryptocurrency networks or ‘blockchains’.
“Digital tokens could enhance wholesale payments”
The CPMI monitors payment, clearing, settlement and reporting arrangements across the world’s financial markets, including large value and retail payment, FX settlement, securities and derivatives clearing and settlement, multilateral netting and collateral management.
“Digital tokens could enhance wholesale payments by allowing the use of new settlement platforms. (for example, based on distributed ledger technology),” the CPMI says in its report.
“This could, in turn, enable alternative access to settlement assets, or enhance efficiency in other ways, such as more frequent settlement, longer availability, harmonised data standards, and richer data/transparency.”
Currently, the settlement of large-value transactions in securities or money takes place in the records of a single settlement institution, such as a central bank, a commercial bank or a financial market infrastructure such as a central securities depositary (CSD).
This centralised infrastructure has developed over the course of decades, reflecting a shift from the storage of paper share or bond certificates towards ‘dematerialised’ electronic registers of ownership.
But since the invention of cryptocurrencies, there has been rapidly growing interest in settlement systems that allow assets to be tokenised and transferred peer-to-peer without a central third party to record the change in ownership.
Notable wholesale digital token projects include the Utility Settlement Coin (USC), which is being developed by a consortium of banks and market infrastructures, and JP Morgan’s payment coin, called JPM Coin.
Tokenisation promises a reduction of risk in the foreign exchange (FX) market
However, says the CPMI, introducing tokenised settlement is a challenge, given the complexity of the current system.
When a securities trade is settled for cash under the current infrastructure, says the CPMI, two systems have to work in parallel: the securities settlement system used to settle the transfer of securities and the payment system used to settle the funds transfer.
To address settlement risk, these financial market infrastructures use so-called delivery-versus-payment (DvP) mechanisms. DvP links a securities transfer and a funds transfer so that the securities leg takes effect only if the corresponding payment is made.
“This process is complex and requires the legal frameworks of the two infrastructures to work together to ensure that security delivery is final only if the corresponding funds transfer is final, and vice versa,” says the CPMI.
A shift to tokenised settlement for securities transactions might generate inefficiencies and add complexity if there were not an equivalent tokenisation of the payments leg of the transaction, says the CPMI.
Tokenisation also promises a reduction of risk in the foreign exchange (FX) market, says the CPMI.
In the FX market, the settlement of transactions between two banks often occurs on a Payment vs. Payment (PvP) basis.
PvP is a settlement mechanism where an intermediary ensures that the final transfer of a payment in one currency occurs if and only if the final transfer of a payment in another currency or currencies takes place.
But PvP settlement of FX trades only accounts for around 40 percent of the market, according to recent figures from the Bank for International Settlements (BIS), which hosts the CPMI.
Last week the BIS warned that settlement risks in the FX market are increasing, driven by a greater share of emerging market transactions in total activity. In emerging markets, PvP settlement for FX trades is not standard.
“Much of the settlement of foreign exchange transactions occurs bilaterally, using correspondent banking relationships without PvP settlement mechanisms (exposing banks to the risk of paying out in one currency and not receiving the countercurrency in return),” the CPMI says in its new report.
Traditional wholesale payment systems are based on long-established legal structures
There is also legal risk in moving from the current settlement system to a tokenised one, says the CPMI.
Traditional wholesale payment systems, such as those for the real-time gross settlement of money movements, are based on long-established and well-founded legal structures, says the CPMI, but the same cannot be assumed to apply to token-based settlement.
“Protections under existing legislation, including payments law, contract law, settlement finality provisions and conflicts of law regimes in their local jurisdictions, were not written with wholesale token arrangements in mind, and may not necessarily extend to such arrangements, leading to possible legal uncertainties and risks,” the CPMI says.
Greeting the new report, Benoît Cœuré, Chair of the CPMI, suggested we are likely to see an extended period of experimentation with digital ledger technology, and that new systems must be judged on their merits.
“There is no single roadmap for success,” Cœuré said.
“Success will depend on whether wholesale digital tokens can provide both improved safety and increased efficiency over the traditional account-based settlement assets used today.”
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